Tuesday, August 12, 2014

The Dark Side of Private Equity?

Three of the leading private equity firms on Wall Street have agreed to pay a combined $325 million to settle accusations that they colluded with one another to drive down the prices of corporate takeover targets, according to a court filing on Thursday.

The three firms — Kohlberg Kravis Roberts, the Blackstone Group and TPG — have agreed to settle all claims without admitting wrongdoing, and they will decide among themselves how to split up the payment, the filing said. Of the seven defendants in the case, all but one have now settled.

The latest agreement, if approved by the Federal District Court in Massachusetts, would resolve the role of the private equity firms in a seven-year-old lawsuit filed by former shareholders of companies that the firms acquired during the boom times before the financial crisis. The plaintiffs, which include pension funds and individual investors, had sought billions of dollars in compensation.

While private equity firms have rebounded strongly from the crash — reaping bountiful profits thanks in part to low interest rates and the soaring stock market — the lawsuit has been a lingering cloud over the industry’s biggest players. The firms, accumulating piles of legal bills, have put up a vigorous defense and succeeded last year in convincing a judge to narrow the case’s scope.

But a trial looms in November, and nearly all of the firms have now opted to pay eight- and nine-figure sums to make the lawsuit go away.

Three defendants — Bain Capital, Silver Lake and Goldman, which did private equity deals through its buyout arm — agreed in recent months to settle the claims against them for a combined $150.5 million.

The agreement with K.K.R., Blackstone and TPG was reached on July 28 though not disclosed until Thursday.

The lone holdout is the Carlyle Group, the giant private equity firm based in Washington. A spokesman for Carlyle, Christopher Ullman, wrote in an email statement: “These claims are without merit and we will continue to vigorously contest the allegations.”

Kristi Huller, a spokeswoman for K.K.R., said in an email statement: “Settling acquisition-related litigation is frequently in the best interest of our investors, on whose behalf we pursue those acquisitions.” She added, “While we continue to believe that the plaintiffs’ allegations are spurious, we determined that after seven years it was best for K.K.R. and our limited partners to put an end to the distraction and expense of this litigation.”

Representatives of Blackstone and TPG declined to comment.

The lawsuit, originally filed in late 2007, took aim at some of the biggest leveraged buyouts in history, portraying the private equity firms as unofficial partners in an illegal conspiracy to reduce competition. Those multibillion-dollar acquisitions were struck by groups of firms in partnership, an arrangement known as a “club deal” that has largely fallen out of favor in the years since.

As they collaborated on headline-grabbing deals — including the buyouts of the technology giant Freescale Semiconductor, the hospital operator HCA and the Texas utility TXU — the private equity titans developed a cozy relationship with one another, the lawsuit contended. Citing emails, the lawsuit argued that these firms would agree not to bid on certain deals as part of an informal “quid pro quo” understanding.

In September 2006, for example, when Blackstone and other firms agreed to buy Freescale for $17.6 billion, K.K.R. was circling the company as well. But Hamilton E. James, the president of Blackstone, sent a note to his colleagues about Henry R. Kravis, a co-founder of K.K.R., according to the lawsuit. “Henry Kravis just called to say congratulations and that they were standing down because he had told me before they would not jump a signed deal of ours,” Mr. James wrote.

Days later, according to the lawsuit, Mr. James wrote to George R. Roberts, another K.K.R. co-founder, using an acronym for a “public to private” transaction. “We would much rather work with you guys than against you,” Mr. James said. “Together we can be unstoppable but in opposition we can cost each other a lot of money. I hope to be in a position to call you with a large exclusive P.T.P. in the next week or 10 days.” Mr. Roberts responded, “Agreed.”

Soon after, the lawsuit contends, Blackstone invited K.K.R. into a bidding group for the radio giant Clear Channel Communications, though the group ended up losing that deal.

Running more than 200 pages, the lawsuit contains numerous references to the protocol of club deals. One unidentified Goldman insider, referring to the takeover of Freescale, said that “club etiquette prevails.” In a different situation, James A. Attwood Jr., a managing director at Carlyle, suggested that “these partnering deals should be a two-way street.”

The plaintiffs, in addition to pension funds in Detroit and Omaha, include several individuals who sold shares in the private equity buyouts. They filed the complaint after the Justice Department’s antitrust division began investigating possible collusion related to club deals. The government never brought any charges.

While the plaintiffs have now coaxed $475.5 million from the buyout firms, much depends on a hearing in September, when a judge will consider whether to approve the settlements and — crucially — whether the plaintiffs can be considered a class for legal purposes. A decision that the plaintiffs are not a class would threaten the existing settlements.Carlyle’s position as the lone holdout creates a risk for the other defendants. The firm, in theory, could object to the settlements.

But pressure will mount on Carlyle if the settlements go forward. Should it lose at trial, Carlyle would be liable for an outsize level of damages. The firm has sought to have the case dismissed, an effort scheduled for a hearing in October.

“We’re gratified that the defendants have decided to settle the case,” said K. Craig Wildfang, a lawyer for the plaintiffs. “We look forward to going to trial against Carlyle.”

This story is still developing but some commentators came out swinging, accusing these private equity giants of evil collusion. Yves Smith of the naked capitalism blog was one blogger who didn't mince her words:

It’s pretty much a given that the underlying conduct smells to high heaven when the top legal fixers in America can’t get seriously rich men out of trouble. In this case, the rich men are the private equity alpha players: KKR, Blackstone, and TPG, who have agreed to shell out $325 million among them to settle claims of collusion on bidding for potential acquisitions. Note that this settlement needs to be approved by the judge to become final. Three other funds, Bain, Goldman, and Silver Lake, already settled with the plaintiffs.

This case was even more of a David versus Goliath than the usual suit against private equity general partners, since the lead plaintiff was the lowly Police and Fire Retirement System of the City of Detroit. Mind you, it’s hard to find any law firm of reasonable stature to go against private equity firms, since they throw around so much legal business that pretty much every blue chip law firm either works for them or wants to get on their meal ticket.

The basis of the dispute was that, in the runup to the crisis, the biggest private equity players would team up to submit joint bids on large takeover candidates. In and of itself, that could be defensible conduct, since one could claim that these so-called club deals allowed the firms to buy even large companies than they could easily (or permissibly, given restrictions in their limited partnership agreements on the maximum percentage of the fund permitted for a single investment) digest. But what was obviously not kosher was arm-twisting other big funds to stand aside. The plaintiffs, who owned shares in the companies that were purchased by these consortia, argued that they were damaged by the price-suppressing effects of these strategies. I have no idea what the rules of thumb are now, but back when I was in the M&A business, having an additional bidder in an auction was generally reckoned to increase the price by 10%.

This private equity troika was eager to cut a deal before September 4, when the judge was to make an initial ruling as to whether to give class action certification to the plaintiffs. If they prevailed, that would greatly increase their bargaining leverage.

She concludes her long tirade by stating:

The fact that these firms managed to drag the case out of seven years suggests they were hoping to win a war of attrition, but the plaintiffs got such good dirt in discovery that that strategy was no longer viable.

A wild card is that one of the defendants, Carlyle Group, has refused to settle. The Grey lady, clearly running PR for the private equity firms, claims the settlement is in jeopardy if the judge rules against the plaintiffs on the class action status. Informed reader input is welcome:

While the plaintiffs have now coaxed $475.5 million from the buyout firms, much depends on a hearing in September, when a judge will consider whether to approve the settlements and — crucially — whether the plaintiffs can be considered a class for legal purposes. A decision that the plaintiffs are not a class would threaten the existing settlements.

Personally, I’d love to see Carlyle executives on the stand, particularly if the stake were high by virtue of refusing to come to terms with the plaintiffs and facing much higher potential damages by virtue of them getting a class action certification. But litigation is a crapshoot, so stay tuned for the September ruling.

While Yves Smith has her panties tied in a knot, quick to accuse these PE firms of illegal activity and spreading absolute nonsense on her blog, others take a more reflective view. Jeff Goldfarb of Breakingviews writes private equity discord is best collusion defense and questions whether firms that are unable to agree to settle could have colluded on deal valuations.

I too find it hard to believe that buyout barons could have concurred on deal valuations. It makes for great conspiracy theories or Hollywood storytelling but the reality is these firms are extremely competitive. They might respect each other but they're ruthless competitors.

Having said this, these large private equity firms have engaged in "club deals" in the past and as I recently commented, they're buying companies from one another in private private-equity deals. So it is possible that they did engage in questionable activity in the past and are willing to settle with plaintiffs to keep any embarrassing details out of the public's purview.

But the fact that Carlyle refuses to settle tells me there is more to this case than meets the eye and I wouldn't be too quick to condemn anyone just yet.

Private equity companies have paid a record 32 per cent of US investment banking fees so far this year, in a sign of the growing power big buyout groups wield in their relations with Wall Street.

Buyout companies accounted for $6.5bn of Wall Street’s $20.4bn in US investment banking revenues from deals so far in 2014, according to Dealogic. That puts them on track to exceed their importance to banks at the peak of the buyout frenzy in 2007, when private equity accounted for 24 per cent of the $36bn of US investment banking business.

These fees have become ever more critical to banks as other formerly lucrative operations have come under pressure and return on equity has been driven down by new regulations and capital requirements.

The recovery from a trough in the crisis year of 2008 when private equity accounted for just 12 per cent of fees comes despite the fact that buyout companies have largely sat on the sidelines of a new wave of multibillion-dollar mergers and acquisitions. Private equity transactions have accounted for only 19 per cent of all such deals globally since the beginning of 2012, Dealogic notes.

The latest data show, however, that private equity houses such as Blackstone and KKR do not need to do big acquisitions to be treasured by Wall Street. Banks are still reaping the fruits of deals done at the peak of the buyout market seven years ago as private equity houses take profits on companies they bought then.Big private equity companies have taken advantage of the Federal Reserve’s easy money policies to refinance the highly leveraged deals they did at that time, paying themselves dividends in the process.

As US equity markets have risen to record levels, they have listed many of their holdings and then sold down their stakes. Investment banks earn fees for such follow-on deals, which is one reason why bankers covet private equity clients.

Blackstone’s initial public offering of Hilton, the hotel chain it bought in 2007, generated $230m in fees, helping make Blackstone last year’s single largest fee payer, handing over $880m. Similarly, in the year to July 25, Carlyle was investment banks’ single most lucrative client, with its $696m total boosted by a large part of the $295m in fees from one of its companies, Numericable. Numericable, which went public late last year and then bought rival French telecoms group SFR, was the largest corporate fee payer for the period, Dealogic found.

“This is an attractive time for [private equity firms] to harvest their gains,” said Craig Siegenthaler, who covers the industry for Credit Suisse. “I expect a high level of monetisations for the next several quarters.”

In the mid-1990s, private equity paid just 2 or 3 per cent of all investment banking fees, according to Dealogic.

The private equity industry's lobbying group met officials from the Office of the Comptroller of the Currency and the Federal Reserve last week to address concerns over a crackdown on junk-rated loans, people familiar with the matter said on Monday.

The private meeting - the first between the Private Equity Growth Capital Council (PEGCC) and the U.S. regulators over the issue - underscores many buyout firms' reliance on leveraged loans for outsized returns in their debt-fueled acquisitions of companies.

It also highlights the willingness of the OCC and the Fed to engage with parties they do not regulate. Private equity firms are typically regulated by the U.S. Securities and Exchange Commission.

The PEGCC sought and received assurances from the OCC and the Fed that regulators have not been targeting the private equity industry in their efforts to prevent excesses in leveraged lending, the sources said.

The OCC and the Fed also told the PEGCC that they were not being inflexible in their application of the lending guidance, which was issued last year, the sources said. The regulators are also working on providing follow-up guidance to banks, the sources added.

Among those attending the meeting were Martin Pfinsgraff, senior deputy comptroller for large-bank supervision at the OCC, and Anna Lee Hewko, a deputy associate director at the Fed's division of banking supervision and regulation, the sources said.

The sources asked not to be identified because the meeting was private. The PEGCC and the Fed declined to comment, while an OCC spokesman did not immediately respond to a request for comment.

The meeting comes as the leveraged finance industry awaits the outcome of an annual review of banks' loan books that took place earlier this summer. Regulators have warned that underwriting standards have deteriorated, though bankers say they expect the review's findings to be in line with last year's.

Lending for U.S. leveraged buyouts totaled $46.9 billion in the first half of 2014. It reached $90.5 billion in 2013, the highest level since 2007, according to Thomson Reuters Loan Pricing Corp.

A small number of PEGCC's members, such as Blackstone Group LP and KKR & Co LP, are alternative asset managers that have direct lending divisions which could benefit from a regulatory crackdown on the leveraged lending businesses of Wall Street banks.

Asked about the impact of the leveraged lending guidance on KKR, Scott Nuttall, head of KKR's global capital and asset management group, told analysts last month the firm stood to benefit on the credit investment side while it would withstand any retrenchment of banks on the private equity side.

"We have direct relationships with a number of institutions around the world, some of which, frankly, are not subject to these potential limitations ... Our private credit business should benefit if the Fed guidelines get adhered to once people figure out what all of the rules actually mean in practice," Nuttall said.

Private equity firms are doing just fine, firing on all cylinders. In fact, if you ask me, it's as good as it gets for private equity and tough times lie ahead.

"It's not a question of enough, pal. It's a zero-sum game: somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another."

So said Gordon Gekko, the anti-hero in Oliver Stone's 1987 film Wall Street, as he perfectly described the financial world's attitude to acquiring more and more money. It will probably be worth recalling that approach this week as we sit through two sets of results from firms just floated by Gekko's branch of finance, private equity.

On the real Wall Street, we get second-quarter numbers from King Digital Entertainment, the UK computer games group flogged to American investors earlier this year. The shares have lost 15% since.

On the same day we also get numbers from the takeaway food website Just Eat, sold to pension funds by venture capital in April, but now 17% cheaper.

There are plenty of similar tales about private equity's class of 2014 – all of which seemed to find obedient fund managers to buy the shares, despite all the warnings about being suckered in at the top of the market.

Still, those pension fund managers criticised for sacrificing our hard-earned money can consult Gekko for a decent riposte: the money has not been lost, they can argue, simply transferred to an alternative perception.

I think there are many pension and sovereign wealth funds that are going to get slaughtered investing in private equity. They're simply not equipped to fully understand the risks they're taking in this illiquid asset class. That's the dark side of private equity that actually worries me the most.

Speaking of the dark side, I was saddened to learn of the death of Robin Williams yesterday. Williams died at the age of 63 from an apparent suicide. He was open about his struggles with drug abuse and severe depression.

My father and brother are psychiatrists and tell me that 10% of the population suffers from depression at one point in their life (life prevalence) and 3% of the population at any given time (point prevalence). And these are people from all socioeconomic backgrounds all over the world. The disease doesn't discriminate between rich and poor but it does strike more women than men.

Luckily most people suffering from depression are easily treated but they have to recognize the signs early and do something about it, especially if it's severe. Employers also need to be informed and provide their employees with resources to battle this and other mental illnesses. Don't ask, don't tell simply doesn't cut it anymore.

Below, Robin Williams' first appearance on The Tonight Show starring Johnny Carson (1981). Williams also discussed his movie "Awakenings" in another funny interview with Johnny Carson in 1991. I also embedded a great scene from Good Will Hunting. He was a real comic genius and a great actor. May he rest in peace.

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